Question

Consider the following AS-AD model.

Aggregate demand:

Y = 200 - 10P

Wage setting relationship:

w = P^e(1 - u)

Price setting relationship:

P = 1.1w

Output and the unemployment rate:

u = 1 - Y/110

1. Derive the AS curve.
2. Solve for the medium run equilibrium output and price level.
3. Suppose P^e = 30. Do you expect P^e to rise or fall? Solve for the equilibrium price and output level when P^e = 30.

4. Suppose Pe = 6. Do you expect P^e to rise or fall? Solve for the equilibrium price and output level when P^e = 6.

When new European Union member countries join the EU they become subject to the European Union competition law – a law that regulates anticompetitive behavior and keeps markets within Europe more competitive.

1. What effect will this have on the new member county’s natural rate of unemployment? Pro- vide a graph supporting your answer.

2. What effects will joining the EU have on the new member’s prices and output? Provide a graph to support your answer.

3. Do you expect higher or lower inflation after the country joins the EU? Explain your answer.

Answer 1

1. From the wage setting , price setting relationship and phillips curve we have,

• 10P/11 =w
• w = Pe (1-u)

10P/11 = Pe (1-u)

.........i

.......ii

equating i and ii, we get relationship between prices and output. This is AS curve.

   

2. In medium run equilibrium, price level is equal to expected prices. Therefore Pe = P

From wage setting relationship, real wage (W/P) is -

W/P = 1 - u ......i

From price setting relationship, real wage is -

W/P = 10/11 ....ii

Therefore unemployment rate u from equations i and ii = 1 - 10/11 = 1/11

Given, u= 1- Y/110

substituting u value in the equation, we have

Y = 110-10=100.

This implies aggregate supply Y =100 is fixed in medium term.

in equilibrium AS = AD

AD : Y = 200 - 10P , or P=10.

at equilibrium output level= 100, P=10

3. Now ,  when Pe = 30

so Y = 100P/30.....AS

Y = 200 - 10P.......AD

in equilibrium( AS=AD) , Y* =50 and P*=15.

Here when expected prices was 30, actual price level is 15. So there is a fall in expected prices.

4.  When Pe = 6

using same AD and AS curve we have, '

AS : Y = 100P/6

AD : 200 - 10P

solving for equlibrium output and prices,

Y*= 125 and P*=7.5

Here when expected prices was 6, actual price level is 7.5. So there is a rise in expected prices.